Dollars and Dragons

I have just published the article below in  the American Conservative.

TOKYO—In the mid 1990s, I published a book entitled Blindside: Why Japan Is Still on Track to Overtake the U.S. By the Year 2000. The prediction in the subtitle did not, as they say, pan out. But it was more soundly based than casual readers of the U.S. financial press might imagine. The book offered a view on exchange rates: I argued that a huge devaluation was desperately needed to save America’s already fast-sinking manufacturing sector.

Had the Clintonites taken my advice, they would not only have halved the dollar’s yen value—taking it from around 100 yen as the book went to press to well below 50—but they would have made similarly aggressive devaluations against other East Asian currencies. Basically, I was advocating another Plaza accord; the original one, drastic though it had been, was not enough. The Clintonites did the opposite, with results that are now abundantly clear to anyone familiar with global trade figures. Japan’s current account surplus, already disconcertingly high in 1990, multiplied more than fivefold by 2010. America’s experience was the mirror opposite: its current account deficit ballooned nearly sixfold.

The Clinton administration’s dollar policy was to “let market forces take their course.” This sounded fine, but in practice it gave the East Asians free rein to keep the dollar ridiculously overvalued, thereby delivering the coup de grace to America’s once peerless manufacturing base.

The Blindside experience taught me two things: don’t bet against East Asian financial bureaucrats, and don’t overestimate American commonsense. As far as the second point is concerned, there has been progress since the 1990s. It is fair to say that many thinking Americans now realize there is no substitute for a strong manufacturing base. It is a bit late, however, as that base is gone.

In fact, the consensus among astute Americans has rarely, if ever, been darker. Certainly this was my impression at Mark Skousen’s FreedomFest gathering in Las Vegas this July. The event’s attendees—a mix of economic thinkers, libertarian political activists, and wealthy private investors—share a common interest in sound money. It was clear that their faith in the dollar has never been lower. Their forebodings are evidently shared in Washington and on Wall Street and have hardly been assuaged by the recent debt-ceiling crisis.

As a panelist in a FreedomFest discussion on China, I was asked how long the dollar might stay aloft before its final flameout. I guessed another five to ten years. I did not advance this with much confidence, however. We are in uncharted territory, and the case for the dollar’s continued role as lynchpin of the world currency systems hardly rests on solid fundamentals—at least not on “fundamental fundamentals” such as trade. On the contrary, the only thing saving the dollar from oblivion is an ardent desire throughout East Asia to keep it on life support.

Even this desire sometimes seems in question. Chinese spokesmen, with their occasional hints that they might abandon the dollar, like to kick sand in Uncle Sam’s face. But in East Asia more than elsewhere, what matters is not what people say but what they do. Having now invested more than $1.2 trillion in U.S. Treasury bonds and other U.S. government securities, the Chinese are clearly walking the walk, even if they don’t always talk the talk. As for the Japanese, South Koreans, Taiwanese, and Singaporeans, they too have been doing their considerable best to forestall a dollar collapse.

This is hardly to suggest the East Asians see U.S. Treasury bonds as a great buy. If anything they are more bearish even than the attendees at FreedomFest. So why do they keep loading up? They could, after all, invest in Europe—there are still some nations there that are not bankrupt. And, of course, there are plenty of hard assets around, not least land and natural resources in promising developing nations such as Brazil, Indonesia, and Russia.

The truth is that the East Asian governments’ investment strategy serves their industrial policy. To keep exporting to the United States, they must finance American consumption, and therefore they must keep adding to their already gigantic dollar stockpile.

It helps that East Asian financial systems are highly regulated, and indeed in considerable measure government-owned. Top regulators evidently lay down quotas for the size of dollar-asset holdings the various institutions should maintain. But even East Asian bureaucrats aren’t all-powerful and, as they are undoubtedly aware, their Canute-like stand against the waves of economic history will soon enough prove futile. The higher they keep the dollar in the short run, the lower it will eventually fall when the fix is in.
Moreover the pressures they must overcome are far greater than in the 1990s, when even the sharpest Americans—not least George Soros and other financial titans—credited greatly exaggerated American press reports of Japan’s problems and placed bets against the yen. What was not sufficiently understood was that Japanese leaders had a strong motive for understating their nation’s strengths and exaggerating its weaknesses. Not the least of their objectives was to keep the yen as low as possible. They also found that their sob stories had a magical effect in persuading a “chivalrous” Washington to cut Japan some slack in trade diplomacy.

Of course, the decisive factor in the late 1990s was that everyone from the Clinton administration to the editors of theWall Street Journal bought into the story that the rise of the New Economy constituted a sort of perpetual free lunch for the United States. As for the ill-starred Japanese, not to mention the Koreans and Taiwanese, the consensus among the American establishment was that, still stuck in the Old Economy, they were destined forever to come off second best against a low-wage China.

The trade figures have not quite followed the script. America’s vaunted new advanced service industries have proved disastrously weak exporters. This helps explain, among other things, the fact that America’s current account deficit hit $561 billion last year, and its bilateral deficit with China alone reached $176 billion.

The contrast with Japan could hardly be sharper. Japan’s trade with China last year was actually in the black to the tune of $46 billion. And Japan’s overall current account surplus, at $194 billion, was a new record. Not bad given the state of global demand.
Key to Japan’s trade success has been that, with the help of a grossly overvalued dollar, it has quietly advanced to leadership even in strategic industries that as recently as the early 1990s were considered impregnable American fortresses. Examples notably include telecommunications and aerospace. You may have missed Japan’s success in telecommunications, but then you probably haven’t studied the innards of your cell phone. According to a study by Deutsche Bank some years ago, there are nine critical components in a cell phone, and Japan dominates them all. Thanks to leadership in laser diodes as well as optical fibers, the Japanese also enjoy a lock on making the physical networks that have made possible our light-speed cyberworld.

Meanwhile, everywhere you look in aerospace, the Japanese dominate in the most advanced components and materials. Only the most obvious example is Japan’s 30 percent share of the new super-advanced Boeing 787. The Mitsubishi group and Toray will make the 787’s super-light carbon-fiber wings, which are its comparative advantage. (What about the 70 percent of the plane that is not Japanese? It would be nice to say it is American, but the officially acknowledged American share is only 30 percent, and that is undoubtedly an overstatement as it counts only top contractors. Many of those contractors rely heavily on foreign sources, not least Japanese ones, for key inputs.)

All this has not gone entirely unnoticed in foreign exchange markets. Indeed, the yen is up 33 percent against the dollar since the collapse of Lehman Brothers in September 2008. Even more interestingly, it is up almost 80 percent since December 1989, the last month before the great Tokyo stock market crash. The yen now rivals the Swiss franc as a safe-haven currency. Even talk of Japan’s vertiginously high government debt ratio has done little to discourage hot money flows.

The world’s money men know something the American press does not: Japan’s debt problem is greatly exaggerated. As the prominent Tokyo-based economic analyst Nicholas Smith points out, there are major accounting problems in calculating a nation’s debt, and adjustments have to be made to published figures to arrive at the real position.

In Japan’s case, the adjustments generally reduce the ratio; the true ratio of debt to GDP, he reckons, is only slightly higher than Italy’s. More important, Japan borrows from itself—only about 5 percent of its debt is held abroad compared to about 25 percent for the United States.

One thing is certain: even at its recent level below 80 yen to the dollar, the yen remains greatly undervalued. Certainly there is likely to be no meaningful improvement in America’s trade position. Nor will Japan’s surpluses diminish.

The present currency system is obsolete and, the best efforts of East Asian bureaucrats notwithstanding, we are headed for a total upheaval in the not too distant future. Of course, there are no obvious candidates to replace the dollar. The major East Asian nations—China, Japan, South Korea, Taiwan—all see the reserve-currency role as a poisoned chalice. So does Switzerland. As for Germany, in the days when it was fully in control of its foreign-exchange destiny, it too always fought the internationalization of the mark. To the extent that the Germans enjoy a veto on European economic policymaking—and they do—they are likely to restrain any move by the euro to replace the dollar.

In the end a compromise will have to be reached, and it will probably take the form of a new unit based on a basket of currencies. The renmimbi, the euro, and the yen will weigh heavily in that basket. The U.S. dollar will also be there, of course, as will the Korean won, the Taiwanese dollar, the Australian dollar, the Swiss franc, and various lesser currencies. That may fix some of the world’s problems. The problem for the United States is that at this stage no amount of currency engineering will bring back its industrial base.

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